The Deal’s Done. But Not the Fees.

There was joy on Park Avenue as the news arrived from Warsaw, a small Indiana city.

Two companies, twin pillars of Warsaw’s economy, had decided to merge. It was the biggest business story to hit the town in decades; an area newspaper, The Elkhart Truth, called the deal nothing short of an “earthquake.”

Back in New York, in the Midtown headquarters of the Blackstone Group, the tie-up meant a handsome payday for Blackstone and a handful of other private equity specialists. Together, they had bought one of the Warsaw companies, Biomet, in 2007. Now they had agreed to sell it for $13.4 billion, or $2 billion more than they paid.

Such is the way of private equity, a signature Wall Street business of the past two decades. The sale — Biomet was bought by Zimmer Holdings, creating a leading orthopedics company — meant a nice return for everyone, including public pension funds that had invested their money in the private equity partnerships that owned Biomet.

But for Blackstone and the other private-equity partnerships in the deal — overseen by Goldman Sachs, Kohlberg Kravis Roberts and TPG Capital — this deal will be a gift that keeps giving. That’s because, beyond the profits they share with their clients, they will be paid millions more in fees — for work that they are never going to do.

In addition to a 20 percent share of gains from the sale, as well as management fees of 1.5 percent to 2 percent charged to investors, the private equity firms will also share in an estimated $30 million in “monitoring fees.” These fees were to be charged through 2017, but given that the deal is expected to close early next year, Blackstone, Goldman Sachs, K.K.R. and TPG will be paid for two years of services that Biomet isn’t receiving.

Private equity is huge. It is now a $3.5 trillion corner of the $64 trillion asset management industry. There are 2,700 of these firms nationwide that use borrowed money to acquire companies that they hope to sell later at a profit. Once called leveraged-buyout firms, private equity firms have changed American business in the 21st century. By buying companies, getting them into shape and selling them — or taking them public — they have brought a focus on efficiency to many companies and generated sizable gains for their investors.

As they have grown, private equity firms have also redefined the upper levels of “rich.” Last year, Stephen A. Schwarzman, who runs Blackstone and has given money and his name to the main building of the New York Public Library, received $375 million in compensation and returns on his investments in the firm; Leon D. Black of Apollo Global Management (he’s a trustee of the Metropolitan Museum of Art, the Museum of Modern Art and Mount Sinai Hospital) received $546.3 million.

That wealth comes largely from the firms’ often-extraordinary profits; Blackstone’s revenue rose 65 percent last year, and Apollo reported a profit increase of 19 percent over 2012. But it also comes from fees — those big fat management fees, and the less obvious pile-on of smaller fees that investors might notice only if they scoured regulatory filings.

Private equity firms say they are completely transparent in their fee disclosures. But that is not the view of the Securities and Exchange Commission, which is taking an increasing interest in private equity — and especially in their fees. The S.E.C., as is its custom, declined to identify any firms that it was investigating, and there is no indication that the Biomet deal is among the transactions of interest to the S.E.C.

Until the Dodd-Frank Act of 2010, private equity firms were relatively free of regulation. The law required that firms with at least $150 million in assets under management register as investment advisers; it also instructed the S.E.C. to take a close look at them. So, over the last year and a half, S.E.C. officials have visited approximately 150 firms and say they have found serious deficiencies in both practice and disclosure at many of them.

“In some instances, investors’ pockets are being picked,” Andrew J. Bowden, director of the S.E.C.’s office of compliance inspections and examinations, said in a recent interview. “These investors may be sophisticated and they may be capable of protecting themselves, but much of what we’re uncovering is undetectable by even the most sophisticated investor.”

The S.E.C.’s findings come as more endowments and public pension funds, looking to diversify and get better returns to pay their obligations, have put their money in private equity investments. From 2006 to 2012, public pension investments in so-called alternatives — hedge funds, real estate and private equity — more than doubled, to 24 percent of total assets from 10 percent, according to a report by Cliffwater, a consulting firm. Private equity investments made up 42 percent of the money pouring into alternatives in 2012.

Private equity firms also raise money from “accredited” individual investors — those the S.E.C. considers wealthy enough — and the firms argue that their investors are savvy enough to understand and agree to the fees they are paying. The Biomet monitoring fees, for example, were stated in a contract, said a representative for all four private equity firms.

“The monitoring-fee agreements were put in place when Biomet was acquired by its current owners,” the spokesman said. “Once the sale to Zimmer goes through, the annual payment of monitoring fees ends, and the monitoring fee agreement provides that a lump-sum present value of future monitoring fees is payable in the form of a termination payment.”

Translation: The contract says Biomet must pay up. And, ultimately, that means less return for the investors.

Certainly, some private equity investors view the fees as the cost of getting a potentially great return. Over the 10 years through September 2013, private equity generated returns of 19.2 percent, annualized, according to Preqin, an alternative-investment research firm. That compares with 7.6 percent for the Standard & Poor’s 500-stock index. In recent years, however, the S.&P. has outperformed private equity.

Noting the industry’s success, Mr. Schwarzman, the Blackstone chairman, told an audience at the Milken Institute Global Conference last month that individual investors — beyond just institutional funds or the accredited wealthy — should be allowed to buy into private equity. These people “should really be able to take advantage of the things the institutions get,” he said.

Money from individuals would also feed growth for private equity — with few regulatory safeguards for those investors. Even the institutions that now invest in private equity might be unaware that they are paying steep fees, Mr. Bowden said. “On money moving from the portfolio company to the adviser,” he said, “there is not a level of transparency sufficient to allow investors to protect themselves, no matter how smart they are.”

Reimbursed, in Part

When Mr. Bowden and his group started visiting private equity firms in October 2012, they didn’t know what to expect. The firms had never been examined. But as teams of two to 10 examiners embedded themselves in firms across the country and started interviewing portfolio managers and compliance personnel, and reviewing records and emails, they quickly identified some problematic practices.

In a recent speech in New York, Mr. Bowden said the agency had uncovered either violations of law or material failings in the way private equity firms handled fees and expenses more than “50 percent of the time” — a significantly higher share than at other asset managers.

Asked about the S.E.C.’s criticisms, Steve Judge, chief executive of the Private Equity Growth Capital Council, the industry’s lobbying group, said in a statement: “Every private equity fund agreement is negotiated by professional investment managers on both sides, creating an alignment of interests that consistently delivers the best returns — net of fees — of any asset class over the long-term.”

Even before the S.E.C. became involved, private equity investors had become frustrated with the high fees in these deals. The standard structure requires investors to pay the management fee on the assets they park in private equity firms and 20 percent of the gains those funds generate.

But private equity firms also charge fees for services like providing merger-and-acquisition advice to the portfolio companies they oversee. Many investors, arguing that they shouldn’t have to pay anything beyond the standard fee structure, began demanding that fund advisers give back a portion of those ancillary fees.

In response, fund advisers agreed to fee-sharing arrangements, in which they would reimburse investors for some ancillary fees. These reimbursements effectively offset the 1.5 percent to 2 percent management fees. In the Biomet deal, for example, the private equity firms are sharing some monitoring fees with their investors, though they declined to say how much.

There are two problems with these reimbursements. Because they can offset only the amount an investor pays in management fees, ancillary fees in excess of those payments are not shared; they are kept solely by the private equity firm. And some fund advisers have found ways to limit the amount of fees they must give back.

One example involves senior advisers hired by private equity firms to help oversee acquired companies. These advisers tend to be corporate executives with experience in a particular industry who work with the acquired companies; a former hotel executive might work with a portfolio of companies in the hospitality business, for instance, to help them run more efficiently.

Traditionally, these executives have been employed directly by the private equity firms, meaning that the firms, not their investors or the portfolio companies, have paid the executives’ salaries, which can be substantial. In other cases, they are paid by portfolio companies, which means that the salaries may be considered a fee to be partially reimbursed to the investors.

Recently, however, some private equity firms have found a way around this. Salaries of executives hired as unaffiliated contractors are not subject to reimbursements, private equity filings show, and by making these people contractors, rather than employees, firms can avoid reimbursing the investors for their costs. The private equity firms also increase profits by shifting the salary of the contractor to the payroll of portfolio companies.

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Andrew J. Bowden, an S.E.C. official, says that “much of what we are uncovering is undetectable by even the most sophisticated investor.”CreditDaniel Rosenbaum for The New York Times

Silver Lake Partners is a huge Silicon Valley private equity firm with $23 billion in assets, including investments in Dell, Groupon and Virtu Financial, the high-frequency trading firm. In a 2014 filing, Silver Lake noted that when it retained “senior advisers, advisers, consultants and other similar professionals who are not employees or affiliates of the adviser,” none of those payments would be reimbursed to fund investors. Silver Lake acknowledges that this creates a conflict with its investors, “because the amounts of these fees and reimbursements may be substantial and the funds and their investors generally do not have an interest in these fees and reimbursements.” Similar language is found in regulatory filings across the industry.

A spokeswoman for Silver Lake declined to comment.

Some institutional investors have criticized the litany of fees that private equity firms charge their investors. At a 2012 conference in London, Sandra Robertson, the investment chief overseeing Oxford University’s endowment, complained about “the tricks we have to look out for such as transaction fees, monitoring fees, fees for paying the fees for your software licenses, fees for visiting limited partners.” She added, with apparent exasperation: “Come on, guys, pay your own bills.”

Consider a regulatory filing by Brazos Private Equity Partners, a Dallas firm with $1.4 billion under management. Its executives and their family members are entitled to generous travel expenses for business functions. The portfolio companies will be billed for expenses that may include the cost of traveling on “commercial or private aircraft or other public or private transportation services such as trains, buses, taxis, personal vehicles, rented or hired cars, shuttles, boats, limos or other vehicles; hotels or other overnight accommodations; parking; meals and beverages; entertainment; and/or other costs of any and all types or descriptions.”

Earlier this year, Brazos announced that it would not raise new money from investors and that it was winding down its current portfolio. A spokeswoman for Brazos did not respond to a request for comment.

Monitoring fees, like those in the Biomet deal, are a source of particular concern at the S.E.C. because of their ubiquity. Portfolio companies generally agree to monitoring for 10-year increments. But when a company is sold, typically after about five years, the monitoring fees for the remaining years of the contract must still be paid.

TPG, the private equity firm with $59 billion under management, has a contract with Par Pharmaceuticals, one of its portfolio companies, stating that Par must pay TPG at least $4 million a year for 10 years. The contract was struck in 2012, but filings show that it will renew automatically each year after 10 years have passed. If Par is sold or goes public, the company will pay TPG the amount of monitoring fees that is left under the terms of the contract, as was the case in the Biomet deal.

A TPG spokesman declined to comment.

There is no evidence that any of these firms are under the regulatory microscope.

S.E.C. officials did describe general practices they find especially troubling, including contracts that renew annually for 10 years. This means that no matter when the contract is terminated by a sale or public offering, there will still be a decade of monitoring fees that must be paid to the private equity firm. Regulators call these evergreen fees.

Ultimately, investors are the ones who lose out when companies pay these fees. Each dollar that a portfolio company pays in fees is one less dollar that it can invest in its operations, thereby shrinking its net worth and ultimate resale value.

Private equity firms don’t have to reveal their investors, but the Oregon Investment Council, which oversees $88 billion on behalf of state employees, is known to be a large investor in several TPG private equity funds. What does it think about companies that pay fees for services not rendered? James Sink, a spokesman, declined to comment, but he did provide a statement from Richard B. Solomon, the council’s chairman.

“We take seriously recent reports regarding the S.E.C.’s investigations,” Mr. Solomon said. “Accordingly, we have directed our consultants and treasury staff to continue to verify that the private equity firms with whom we invest have assessed only those fees allowed by the terms and conditions of their contracts.”

‘Temptations and Conflicts’

In recent testimony before Congress, Mary Jo White, chairwoman of the S.E.C., praised the agency for helping investors recoup money from private equity firms. She said the agency has “facilitated millions of dollars in reimbursements by private equity advisers” since 2012. These reimbursements represented fees and expenses that were not properly disclosed to investors.

The S.E.C. recently filed a complaint against a small private equity firm, contending that it entered into undisclosed revenue-sharing agreements through which it received kickbacks in return for recommending investments to its clients. The firm, Total Wealth Management, is based in San Diego and oversees $90 million in client assets. The firm did not return phone calls seeking comment.

It is unclear whether the S.E.C. will refer any cases arising from its 18-month review to its enforcement division. But agency officials like Mr. Bowden suggest that, failing public disclosures and oversight, improper or excessive practices will continue.

“A private equity adviser is faced with temptations and conflicts with which most other advisers do not contend,” Mr. Bowden said in the recent New York speech. “We have seen that these temptations and conflicts are real and significant.”

A version of this article appears in print on , Section BU, Page 1 of the New York edition with the headline: The Deal’s Done. But Not the Fees.. Order Reprints | Today’s Paper | Subscribe